Understanding Behavioral Finance

Behavioral finance is a relatively new field of study that is starting to gain popularity amongst both the mainstream and economists and finance experts. At it’s core, behavioral finance seeks to provide explanations as to how the human behavior and psyche can influence financial decision making. Understanding behavioral finance can give you a leg up when it comes to managing your finances and investing.

For a long time, empirical evidence suggested that the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) did a pretty good job of predicting and explaining certain events. However, as time went on, academics started to find particular behaviors and discrepancies in these traditional theories that had no explanation. What they ultimately discovered is that these theories can only explain events where it is assumed that people (investors) behave rationally and logically. The reality, though, is that the real world is actually a very messy place where market participants frequently behave irrationally.

The Emotional Aspect of Money

Just contemplate for a second on the emotional relationship you have with money and some of the irrational decisions you’ve made in the past as a result. Ever bought a lottery ticket? Your odds of winning the lottery can fall in the ballpark of roughly 1 in 146 million. That translates to approximately a 0.0000006849% chance of winning. With those odds, you might as well pull every dollar bill you’d spend on a lottery ticket out of your pocket and light it on fire because the result is more likely to be the same than not. It is an irrational decision to buy a lottery ticket, but you do so anyway because of the emotional excitement you feel at the thought of winning it big no matter the odds.

Another great example of irrational behavior with money is what we saw in the Great Recession that began in December 2007 and ended in June 2009. On March 6, 2009, the Dow Jones Industrial Average (DJIA) hit a record-breaking low of 6,443.27, having lost over 54% of its value since October 9, 2007, high of 14,164.53. When the Dow hit its all-time low, a lot of people had already lost entire fortunes and you know why? They made the single biggest mistake you can make investing – buying high and selling low. Logic would dictate that it is irrational to buy something at a high price and sell it at a low price because you lose money. Nobody would disagree with that, yet millions of people still did so. Watching their fortunes slip away on paper stirred up a tremendous amount of fear and anxiety, their emotions got the best of them, and they liquidated their portfolios to try to cut their losses. In reality, though, they just lost a whole bunch of money, far more than they would have had they not sold and remained invested instead. In fact, those that remained invested and went on a buying spree in the market actually made many multiple times more money after the market recovered than those that didn’t because they were able to remain calm and rational, and take advantage of the opportunity to buy really low.

With that said, it’s amazing how the markets can fluctuate so wildly based purely on emotion and an abundance of sensationalist media. We’ve seen it happen time and time again despite what the fundamentals of the market may be telling us. These types of phenomena are what behavioral finance aims to explain. As financial planners, we live and breath behavioral finance whether we realize it or not. Everything we do is geared towards understanding what emotional factors drive our clients’ decision-making process and then using that information to help them avoid irrational decisions when their emotional responses take over. The big question now, is how can we further implement what behavioral finance teaches us and use it to our advantage?

Another great Warren Buffett quote sums it up pretty well:

“Be fearful when others are greedy and greedy when others are fearful.”

If you’d like to discuss the risk your currently taking in your portfolio, or how we may be able to assist in portfolio management, schedule a free consultation today.